The Fed and ECB at a crossroads: Unwinding QE
Last week, the European Central Bank dropped the easing bias from its communique, while the Federal Reserve's FOMC is meeting on 13-14 June with speculation high that they will raise rates yet again. After years of quantitative easing and low interest rates, the Fed and, to a lesser extent, the ECB appear to be ready to get out. Both central banks are at a crossroads as the decision to unwind QE could prove to be fatal or come at just the right time.
We asked Dr. Constantin Gurdgiev, who runs the blog True Economics as well as the website MacroView, for his thoughts on the matter. More specifically, how exactly will the Fed unwind its multi-trillion dollar balance sheet without severely upsetting the bond and equity markets and how will the ECB, which is still stuck in a quantitative easing cycle, be able to bring it to an end without plunging Eurozone countries into yet another financial crisis?
Dr. Constantin Gurdgiev is Professor of Finance at Middlebury Institute of International Studies at Monterey and continues as adjunct assistant professor of finance at Trinity College, Dublin. He is a co-founder and director of the Irish Mortgage Holders Organisation. Constantin is proudly a board advisor to Aid:Tech, a revolutionary blockchain technology firm that works to merge technology and aid. He serves as a partner and a board member with a number of international financial services providers, and he is the board member of ICham Irish Chamber of Commerce in Central and Eastern Europe. Dr. Gurdgiev was one of FocusEconomics's Top Economic and Finance bloggers of 2016. Visit his blog True Economics as well as his website MacroView for more from Constantin. You can also follow him on Twitter here.
Top of the line:
Years of unprecedented monetary policy ‘accommodation’ around the world has resulted in severe mis-pricing of key risks by the global bonds and equities markets. Given the depth of the government debt markets and their pivotal importance to key long-term investment markets, such as pensions funds, insurance companies and retail investors, and given the strong channels for spillovers/contagion from the bonds markets to equities, both markets are now primed for a massive correction, once interest rates reversion to the historical mean takes hold. This mean reversion is now looming as the Central Banks - from the U.S. Fed to ECB and Bank of Japan - either contemplate or already acting to raise rates and reduce their balance sheet exposures accumulated during the period of the crisis.
Take for example U.S. Treasuries. Since mid-2013 through today, U.S. Treasuries yields have closely followed global CPI measures, with the gap between U.S. 10 year yield and the IMF-measured Global CPI gauge widening starting in mid-2015. Currently, 10 year treasuries are trading at a yield of around 2.2 percent against the Global CPI closer to 2.8 percent. This represents a reversal of the historical relationship over 2000-2007 period, when yields on the U.S. 10 year bonds run at an average premium on Global CPI gauge.
In simple terms, the further the U.S. Treasuries depart from the Global CPI, the greater the negative impact on the U.S. bonds prices will be once the Fed and the global Central Banks get serious about moving toward higher interest rates. And, in line with this, the greater the negative impact will be on financial services intermediaries and investors heavily dependent on U.S. and other advanced economies' bonds. Given the complexity and the severity of contagion channels through which bonds repricing in the global markets can impact investors’ portfolios valuations, returning U.S. treasuries and other government bonds markets to more realistic, fundamentals-justified risk valuations threatens severe corrections in both debt and equity markets worldwide.
The Fed has already started to gradually unwind its monetary accommodation, primarily through recent rate hikes, but also by curtailing active purchasing of the U.S. Treasuries and agency debts, as well as MBS. Since mid-2014, the Fed balance sheet remains flat, while reserve balances held with the Fed have declined marginally. Thus, total balance sheet exposure by the Fed is running at around USD 4.4 trillion, unchanged from the start of 2017. The next steps of unwinding for the Fed are likely to involve 2-3 more interest rates rises in 2017 and gradual reductions in assets rollovers (purchases on new securities that are issued to roll over maturing assets). However, this gradualist approach to monetary policy tightening will likely lead to markets taking Fed policy changes as forward guidance for 2018-2019 policies, resulting in potential repricing of risks ahead of actual policy changes. This, in turn, presents a significant risk of a severe markets correction towards the end of 2017.
An added risk dimension here relates to political risks and economic policy shocks that can simultaneously push up inflationary expectations (e.g. Trump Administration proposed tax reforms and a patent lack of budgetary discipline are both inflation-positive) and create an added safe haven demand for financial assets (e.g. ongoing and expanding geopolitical tensions and domestic investigations relating to the Presidential Administration are both equities and U.S. bonds negative). These factors, if they coincide with the Fed policy tightening, will further exacerbate any equities and bonds prices correction, and can lead to a potential run on the markets. Beyond this, Fed tightening runs against the massively expanded debt exposure for the U.S. and global corporates and the U.S. households. This channel of monetary policy tightening impact risks triggering a new debt recession with likely global implications.
Hence, the Fed finds itself in an extremely sensitive position. Even a moderate tightening path to policy normalization can result in a severe market crisis with strong contagion channels to systemically-important financial institutions, including larger banks, pension funds and insurance companies. On the other hand, continuing with business as usual monetary policies means risking an inflationary uptick that cannot be addressed without forcing the U.S. economy into another recession. It further undermines sustainability of the U.S. public and private pension funds. In one key example, in 2016, CalPERS, the largest public pension system in the U.S., covering public pensions provision across California, has generated a return on its investments that is more than ten times below the long term sustainable rates of returns factored into its contractual pensions payouts. The longer the current period of monetary accommodation lasts, the more insolvent public pensions across the U.S. become.
In its latest guidance, issued on 8 June, the ECB remains committed to the promise of continued monetary expansion over the course of 2017. In line with this, the ECB continues to aggressively accumulate assets, with the end-of May balance sheet sitting at USD 4.6 trillion, above the Fed’s USD 4.4 trillion and BoJ’s USD 4.5 trillion balance sheet exposures. Like the Fed, the ECB is facing the same monetary policy dilemma. Inflationary expectations are rising in the Euro Area, with short-term indicators for inflation currently at or above the ECB policy target levels and medium-term HICP close to the target. At the same time, long term viability of the current debt-fuelled expansion rests solely on the assumption that the low interest rates environment will remain in place well into 2020 and beyond. Spillovers in assets demand from the U.S. and the rest of the world into the euro area have triggered similar risk mis-pricing in European equities and bonds that characterizes the U.S. markets. In contrast to the U.S. and Japanese monetary authorities, however, the ECB is currently running too close to exhausting the supply of key benchmark German bonds it can buy over the rest of 2017. Given idiosyncratic nature of ECB mandate and the complex structuring of its asset purchasing programs, this problem of dwindling supply of German (and other highly rated) government bonds available for purchases under the ECB programs imposes significant risk spillovers from the Frankfurt policy to private sector financial intermediaries, including pension funds and insurance companies, as well as the banks.
In other words, like the Fed, the ECB is at a cross roads when it comes to its policies forward: either tighten rates and balance sheet exposures soon in order to bring asset markets bubbles under control, or continue to inflate the debt bubble. The former option risks triggering a market crash and a recession, just as the labour markets starting to slowly recover from the previous crisis, the latter option promises to create an even greater blowout in the future.
Given these choices, the ECB is likely to continue monetary accommodation into 2018, while starting to ‘taper’ the rate of its balance sheet expansion. Unlike the Fed, the ECB will hold off from non-replacing maturing assets with new issuance purchases for as long as it can in hope that either Frankfurt can restructure its asset holdings away from strict GDP-share targeted sovereign exposures or that Brussels comes up with a reasonable burden-sharing fiscal harmonization plan.
5-year economic forecasts on 30+ economic indicators for 127 countries & 33 commodities.
Date: June 13, 2017
TagsUkraineTunisiaEmerging MarketsAustraliaMexicoG7European UnionEuro AreaGoldOilNordic EconomiesAgricultural CommoditiesRussiaVenezuelaForexColombiaCompany NewsUnited KingdomEastern EuropeEurozoneIranSub-Saharan AfricaLatin AmericaItalyIndiaExchange Rateoil pricesEconomic Growth (GDP)TurkeyJapanCanadaUKUnemployment rateSpainFranceMENABrazilGermanyConsensus ForecastPortugalUSAInvestmentOPECVietnamChinaPrecious Metals CommoditiesUnited StatesMajor EconomiesTradeBrexitHealthcareInfographicSouth AfricaCommoditiesCryptocurrencyBitcoinInflationAfricaHousing MarketBanking SectorArgentinaprecious metalsEnergy CommoditiesBase Metals CommoditiesAsiaIMFTPPGreece
In 2019, Central America and the Caribbean should continue to benefit from robustalbeit moderatingmomentum in the… https://t.co/s8TcEK24S7
14 hours ago
FocusEconomics analysts put Brazilian growth at 2.3% this year, which is down 0.1 percentage points from last month… https://t.co/vD0ZZjumLN
17 hours ago
20 hours ago
20 hours ago
Base metal prices are seen rising 5.9% year-on-year in Q4 2019 (previous month: +6.2% yoy). Read more: https://t.co/KlgaC9IbxP
1 day ago
- Brexit Scenarios: Consensus of 14 Economic Analysts
- Sweden just formed a new government and approved its 2019 budget: what does it mean for the economy?
- Which countries have the highest public debt levels?
- Predictions for the global economy in 2019 from 13 experts
- Gurdgiev: Predictions for the global economy in 2019
- Daniel Lacalle's ideas for 2019: Change of cycle.
- Vietnam Poised to Profit from Free Trade Agreement Opportunities
- Canada in 2019: Interview with a Top Economic Forecaster
- Pound Sterling 2019 Exchange Rate: Projections from Leading Analysts
- Expectations for Latin America’s Economy in 2019
- Ethiopia and Rwanda: From Destruction to Development
- Key commodities trends to look out for in 2019
- What drove Gulf neighbors to bail out Bahrain?
- The Four Financial Bubbles and Their Impact on the U.S. Economy
- The Poorest Countries in the World
- Italy: The sick man of Europe
- What does Bolsonaro's presidential win mean for Brazil's economic outlook?
- The World's Top 10 Largest Economies
- In Latin America, taxpayers are tapped to shoulder the burden of a bank bailout
- How and when will the next financial crisis happen? - 26 experts weigh in
- China and Africa: A partnership under the spotlight
- The conditions are ripe for a Global Financial Crisis 2.0
- Uncertainty, instability and fear haunt a generation of Argentinians
- 5 things: What to expect for Mexico's economy in 2019
- 5 things: Brazil's economic downturn and what to expect going forward
- Emerging Market Currency Crisis: Everything you need to know
- Which ASEAN countries are most exposed in the event of a U.S.-China trade war?
- 75 Top Economics Influencers to Follow
- Emerging Markets Economic Outlook 2018 and 2019
- The Faces Behind Latin America’s Key Institutions
- 2019 Economic Outlook for the Top Oil Producing Countries
- Is your cup of coffee about to get more expensive going in to 2019?
- The Economic Implications of an Aging Global Population
- Railway Mania: The Largest Speculative Bubble You’ve Never Heard Of
- Can the Wisdom of the Crowds predict the results of the 2018 World Cup?
- From Riches to Rags: Have Cryptocurrencies Crashed for Good?
- Investment looks to Latin America, but forecasts are not encouraging
- Turkey: Erdogan has cemented his grip on power - now what about the economy?
- How can Latin America’s business environment benefit from technological change?
- Mexico: A look at the past, present and future as elections yield AMLO victory
- Italy’s New Populist Government and the Eurozone: Prelude to a Crisis?
- Latin America moves toward increased integration as U.S. protectionism grows
- How can Latin America increase productivity without affecting the quality of employment?
- How will Saudi Arabia's economy benefit from lifting the women's driving ban?
- Which countries are the most prepared for the upcoming digital revolution?
- India Under Pressure from the U.S. on Trade Policy
- The Story of Steel
- Latin America is the World Leader in eCommerce Growth Despite Serious Challenges
- What the TPP means for trade in Latin America
- Elections in Russia: Analysis and Implications
- Nearly a Third of Latin Americans Have No Right to a Pension
- A Look at Healthcare Models Around the World
- Newly-elected Chilean President Sebastian Piñera faces a myriad of challenges - economic and otherwise
- The Economic Effects of Trade Protectionism
- Regional Disparity: The Dark Side of Inequality in Latin America
- Coal: The story of the world's most abundant fossil fuel
- Venezuela's Electoral Conundrum
- Gold: The Most Precious of Metals (Part 3)
- Trump's 1st Year: 95 Analysts Surveyed on U.S. Economy
- The Latest on China and What's in Store for 2018
- An in-depth look at the Eurozone’s booming economy and the challenges that lurk in the shadows
- Increasing poverty in Latin America takes a breather thanks to improving economic dynamics
- What will be the most miserable economies in 2018?
- Is Spain doing enough to address its high youth unemployment rate?
- Has Latin America gone far enough in reducing barriers to international trade?
- Commodities Outlook: Oil, Natural Gas, Coal, Lead & Tin
- 21 experts tell us what the future looks like for cryptocurrencies and blockchain
- Turkish lira plummets to all-time low on Erdogan’s monetary feud and tense U.S.-Turkey relations
- Copper: The first metal mastered by man
- The Mercosur-EU Free Trade Agreement: Obstacles & Opportunities
- Nigerian Economy Still Treading Water Thanks to Oil Sector
- Elections in Chile: What the results could mean for the economy
- QE’s Untold Story: A Chart That Fed Correspondents Need To Investigate
- Holland’s fragile one-seat majority government targets economic growth at the expense of fiscal sustainability
- South Africa: Economy at a tipping point?
- Latin American Commodities: What’s behind the increase in demand and prices?
- Is the UK really "shackled to a corpse"?
- Spain-Catalonia: 7 economic experts weigh in on how the situation will affect the outlook
- How well is Spain's labor market doing since the crisis?
- Which countries will have the highest and lowest inflation in 2017?
- How vulnerable is Latin America to economic crises today?
- Iron ore facts and common questions answered
- The bulging economic costs of obesity
- How much investment is needed to salvage Latin America’s crumbling infrastructure?
- A Look at the Potential Impact of Brexit on the Dutch Economy
- Emerging Markets Are Kicking Into Higher Gear In 2017
- Why is foreign direct investment in Latin America falling again?
- Bounty or burden? The impact of refugees on European economies is far from clear
- Are Central Banks Nationalising the Economy?
- What’s the future of U.S.-Latin America trade relations?
- Taxes or cutbacks? Latin America's challenge of sustaining spending without causing debt to skyrocket
- Are uranium prices making a comeback?
- Taxing the Economy: Achieving a Delicate Balance
- How will Latin America’s upcoming lengthy election cycle affect the reform agenda and credit ratings?
- How will emerging market economies perform in 2017?
- Chilean Economy in Focus: Interview with Senior Economist of the Chamber of Commerce of Santiago
- CEOs Rank Top Economies for Growth Opportunities
- The Mobile Ecosystem & Latin America's Economy
- Prospects and Challenges for the Global Economy: Interview with Tim Cooper from BMI Research
- How will the Fed reduce its balance sheet & and how will the ECB end QE? - 19 economic experts weigh in
- Thoughts on "unwinding" QE from Frances Coppola
- The Fed and ECB at a crossroads: Unwinding QE
- Spain: The economy that continues to silence the critics
- Latin America: The Most Unequal Region in the World
- The History of OPEC: Has it been a Success?
- FocusEconomics Announces 2017 Analyst Forecast Awards Winners
- Latin America’s rising unemployment bucks nearly decade long trend
- Escape from the Central Bank Trap by Daniel Lacalle
- China's economic rebalancing act: What to look out for in 2017
- Driving Growth in Latin America: Challenges & Priorities
- Is the Global Economy Rebalancing?
- Commodity exporters face challenging times
- Recent Global Events Facilitate Mercosur-Pacific Alliance
- 23 economic experts weigh in: Why is productivity growth so low?
- Mexico's outlook as Trump nears 100-day mark
- Interview with Oxford Economics Senior Economist on implications of the possible outcomes of the French Presidential Election
- The anxiety of the small saver in a world of negative interest rates
- Brexit negotiations. Between Uncertainty and Urgency
- An Economic History of the EU from El Blog Salmón
- Baby Boomin': Implications of high population growth in Latin America
- Survey of International Economists Predicts a Le Pen Defeat in French Elections, Says Macron has Best Economic Plan
- Spain in a global context: developed economy with some challenges
- How much is crime costing Latin America?
- Predictions & Estimates from Economist Daniel Lacalle
- What economy will the new Dutch government inherit?
- “The data is not a true reflection of reality in India” Interview with Société Générale India Economist
- What are the prospects for Emerging Economies in 2017?
- What to expect in Asia for 2017
- Top Economics & Finance Blogs of 2017
- Latam to Resume Moderate Growth in 2017 but Important Risks Plague Outlook
- 4 Key European Elections That Will Impact the Economy in 2017
- How are security concerns and political chaos affecting Turkey’s economy?
- Global growth to edge up in 2017
- Set to breach targets again? Debt and deficit outlooks for Southern European Eurozone countries in 2016 & 2017
- What does Donald Trump mean for the U.S. economy?
- How will emerging markets perform in 2017?
- The economic impact of a break in U.S.-Philippines ties
- Trump election: Base metals surge due to infrastructure plan
- 5 updates on the Venezuelan economic crisis
- Canada: When your neighbor’s house is on fire…
- Short-term pain before long-term gain? A look at French labor reform and economic growth
- Asia: Unremarkable growth & unfulfilled promises?
- How India's latest monsoon is affecting the economy
- Russian economy update in wake of OPEC deal announcement
- Innovation in Latin America: Potential Goes Untapped Due to Weak Economic Conditions
- The Wisdom of the Crowds and the Consensus Forecast
- Can the peso predict the U.S. election results?
- There's no end in sight to the Venezuela crisis
- A Look at the European Union Political Calendar
- Survey of international economists shows uncertainty surrounding elections damaging U.S. growth prospects
- FocusEconomics partners with leading online statistics provider Statista
- China: Recent postive economic data may be papering over the cracks
- Sub-Saharan Africa's 2016 & 2017 growth rates
- The Italian Dilemma: Weak banks pose risk to already faltering domestic demand
- How much money do migrants from Latin America send home?
- The U.S.' (Not So) Mysterious Case of the Missing Men
- What to expect from the G20 economies by 2020
- The Pain in Spain: Robust GDP growth cannot mask the persistent structural deficit